TSC21: Smurfit's Boxes May Hold Key to Recovery

The cardboard box maker is a great gauge of the prospects for U.S. manufacturing. What will earnings show?
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Today's feature on Smurfit-Stone is part of our ongoing coverage of TheStreet.com 21, a new index of 21 companies designed to be a leading indicator of the economy's direction for the rest of the year and beyond. We will profile Smurfit and the rest of the index's components in the coming weeks.

Click here for an introduction to the TheStreet.com 21, and click here for a chart listing the components and their reason for inclusion.

If the economic recovery arrives wrapped up in a tidy little box,

Smurfit-Stone Container

(SSCC)

would probably provide the package.

The manufacturing outlook has been tough to handicap, percolating in fits and starts only to crumble again -- the U.S. manufacturing sector had its fourth-straight month of contraction in June. If and when business improves, box makers would be among the first to benefit, and Smurfit's business outlook will best signal a reversal of fortune -- or more economic doldrums.

The world's largest maker of cardboard boxes makes containers for

Canon's

(CAJ) - Get Report

printers,

Budweiser's

(BUD) - Get Report

case shipments,

ChevronTexaco's

(CVX) - Get Report

Havoline oil cans and a host of

Disney's

(DIS) - Get Report

products, just to name a few customers. These clients don't keep high inventory levels of boxes, so Smurfit's earnings and outlook will speak volumes about the state of the manufacturing sector and about whether the U.S. economy is indeed picking up.

"If you believe the U.S. economy is going to be reinvigorated by lower interest rates, then Smurfit-Stone is the best way to play it in paper," said Steven Chercover, an analyst at D.A. Davidson. "It's the most pure play on U.S. manufacturing."

The Outlook

When U.S. business is flat, so are Smurfit-Stone's earnings. Indeed, Wall Street expects the company to post a second-quarter loss of 4 cents a share on July 29, according to the Thomson First Call consensus estimate of nine analysts.

In April, the company posted a worse-than-expected first-quarter loss of 10 cents a share, which it blamed in part on higher energy costs. Analysts expect the company to post an 8-cents-a-share loss for 2003.

Though the company has demurred on providing a full-year outlook because visibility is so short term, Smurfit has signaled this spring that second-quarter results may end in the black. Indeed, CFO Charles Hinrichs told a conference in May that the macroeconomic environment appears to be improving -- the proof of which may be in the company's second-quarter numbers and second-half guidance.

A Proxy for U.S. Manufacturing

Unlike rivals in the paper space with international operations, Smurfit-Stone is primarily based in North America, having exchanged its European packaging operation for a stake in a Canadian packaging business in December 2002. "It's hard to compare the company to where it was in the late '90s, since it's not the same company anymore," said Chercover.

The close link between Smurfit-Stone and the U.S. manufacturing outlook is especially clear when you compare the company's stock price with the purchasing manager's index, or PMI, which is released by the Institute for Supply Management. Any reading above 50 represents an expansion in manufacturing, while any number below 50 represents contraction. And as the chart below shows, when the PMI falters, so does Smurfit-Stone's share price.

The Economy in a Box
When PMI slides, so do shares in Smurfit-Stone

Sources: Institute for Supply Management, Yahoo! Finance
* -- as of the end of the month.

While the

S&P 500

has jumped 25% since March 11, Smurfit-Stone's share price has gained 14%, lagging the broader market in the same way the PMI compares with the ISM index for nonmanufacturing, which came in at 60.6 for June.

Meantime, the company's bellwether role for the paper-products industry also provides a glimpse into how that segment of manufacturing is holding up. According to the American Forest and Paper Association, the industry employs 1.5 million people, accounts for 7% of total U.S. manufacturing output, and is one of the top 10 manufacturing employers in more than 42 states.

Interest Rates, Energy and Dollars

On a more specific level, some of the factors affecting the U.S. manufacturing sector -- such as falling interest rates, rising energy prices and a weaker dollar -- also affect Smurfit-Stone's business, making the company an even better economic gauge.

For example, Smurfit-Stone saw definite benefit from the

Fed's

constant cutting of interest of rates, reducing its interest expense by $6 million last quarter and lowering its overall effective interest rate by 44 basis points from the year-ago quarter. But as with the overall economy, the advantage Smurfit-Stone gained from rate cuts was limited compared with that from other economic factors, such as rising natural gas prices.

"The paper industry is very energy-intensive. It requires a lot of brute force to take a tree from its solid form and turn it into pulp and then reconstitute that back into paper," said Chercover.

And Smurfit-Stone relies heavily on natural gas, which is in such tight supply that even Alan Greenspan has been commenting on it as a potential recovery risk. And with natural gas prices up 14% this year, spiking to a record $12 per million BTUs in February, the trend certainly has had a negative impact on Smurfit-Stone, which spent $140 million on energy costs in the first quarter, up $29 million, or 26%, from year-ago levels.

Also, because of the euro's newfound strength, the U.S.-based paper company is taking a hit, with currency exchange losses totaling $16 million last quarter. While the weak dollar should make for stronger exports, the currency effect is being offset by more aggressive competitors, especially China, which has its currency pegged to the U.S. dollar.

"The drop in the dollar hasn't had more of an impact because the Chinese currency has come down with it," said Stephen Atkinson, analyst at BMO Nesbitt Burns. "And with no gain with regard to

China, and given that they're the largest exporter to the U.S., logically, we've not seen any pickup in demand."

In the end, Smurfit-Stone and the U.S. manufacturing sector are at a similar crossroads. After years of cutting costs and being unable to raise prices, there's less that can be done to boost earnings. What both need most is for demand to perk up finally -- without it, any recovery is bound to falter.

"It really does come back to box consumption. There's weak demand, holding prices, but in order to gain momentum, that's going to take a pickup in demand," said Atkinson, who notes that he has the company rated at market perform. "We're waiting for good news before we raise our rating."

(None of the analysts mentioned in this story have any banking relationships with Smurfit-Stone.)